S1E7: In Pursuit of Scale - The Strategies of Africa-Focused Venture Investors

Justin S [00:12]: There was no Valley-style proper VC being done here and being entrepreneurs as well, we figured well, we should do something about this there's an opportunity here. There's demand but there's no supply.

Justin [00:26]: That's Justin Stanford, a Founding Partner of the Cape Town-based venture firm 4Di Capital. Justin was one of the first VCs I sat down with to better understand the venture investing landscape in African markets. And while Justin and 4Di Capital were inspired by the successful ecosystem in Silicon Valley, building a successful firm in an emerging market results in some key differences.

Justin S [00:46]: That's why I say Valley inspired and not exactly copied - because the US-style relies on a bigger, more vibrant ecosystem. The structure and the setup was modeled pretty much exactly on the Valley way of doing things, but our approach to the portfolio was maybe a little more careful.

Justin [01:06]: Last episode-episode six- we discussed fundraising from an entrepreneur's perspective. In this episode-the second of our three part series on venture investing in Africa- we head over to the other side of the table and talk to the venture capitalists themselves. What does venture investing look like across the continent? What are the key differences here versus in an ecosystem like Silicon Valley, or in the west in general? What are the implications of these differences, from a decisionmaking and investing perspective? And what funding and support models seem to be working well in this environment? Time to zip up our Patagonia vests and talk to some VCs.

VO [01:51]: You're listening to The Flip, the podcast exploring more contextually relevant stories from entrepreneurs around Africa.

Justin [02:01]: Welcome back to The Flip, I'm your host Justin Norman.

For most of this season, we've talked to entrepreneurs solving local problems around the continent, to further explore and champion the African startup ecosystem - with all it's challenges, complexities and nuances. It should go without saying that the environment is different - the problems are unique, the markets are unique, and the solutions and the business models are unique. But what about venture investing - what does that look like?

In this episode on venture capital, I think it's useful to first define what it is and what are is characteristics. For that, I've borrowed writing from Ben Thompson of Stratechery, a popular and tremendously insightful blog on the business and strategy side of the tech industry. In a post entitled "What Is a Tech Company?", which I've linked to in the show notes, he writes - [The] critical factor that makes tech companies unique: the zero marginal cost nature of software. To be sure, this wasn’t a new concept: Silicon Valley received its name because silicon-based chips have similar characteristics; there are massive up-front costs to develop and build a working chip, but once built additional chips can be manufactured for basically nothing. It was this economic reality that gave rise to venture capital, which is about providing money ahead of a viable product for the chance at effectively infinite returns should the product and associated company be successful. To summarize: venture capitalists fund tech companies, which are characterized by a zero marginal cost component that allows for uncapped returns on investment.

A key phrase in Ben's definition is "for the chance at effectively infinite returns should the product and associated company be successful". In other words, high risk, high reward. And if at least 3 out of every 4 startups fail, that means that venture capitalists need to invest in a lot of startups to improve their odds of having a so-called unicorn in their portfolio. It is also why VCs look for so-called unicorns - who have the growth potential to cover the return expectations for the fund. And Silicon Valley VCs have large fund sizes, not only to enable them to build a big portfolio of companies but because of the ecosystem's track record - VCs have made their investors a lot of money investing in the asset-lite, software-based companies that are the Silicon Valley archetype today.

So with all of that said - what does the venture landscape look like across Africa? And what are the key differences? Let's start by exploring what VCs are looking to invest in - and given the high risk/high reward nature of venture investing, this centers around one clear theme: scale.

Chidinma [04:10]: My name is Chidinma Iwueke.

Dayo [04:12]: My name is Dayo Koleowo.

Justin [04:15]: Chidinma and Dayo are two of the Partners at Microtraction -

Dayo [04:18]: Microtraction is an early-stage angel investment fund that was founded to fill the pre-seed funding gap that we had identified in the African ecosystem.

Chidinma [04:29]: We invest in technology-enabled businesses. We're looking for companies that are using technology to solve some of the most interesting problems within the African market.

Justin [04:43]: Venture capital, by definition, is an investment in technology businesses because the technology is what makes the company - and software companies in particular - borderless and infinitely scalable. And to scale, Microtraction - which is based in Nigeria, Africa's most populous country, likes to start with large markets like their own -

Dayo [04:59]: We believe in very large markets. We love solutions that can reach very large sets of target audience and of course, solutions that can scale to other markets with technology. We believe that it's impossible to build a venture scale company in a small market that's not growing fast.

Justin [05:19]: The large markets sentiment was something echoed by Ido Sum, Partner at TLCom Capital.

Ido [05:25]: Generally speaking, we're looking for very strong teams who are after very large markets in the African context. Or in other words, companies that are up for solving large scale African problems, typically in more than one market, with very few exceptions - maybe in regards to Nigeria - and using technology for scale, affordability and innovation around new solutions for large size problems.

Justin [05:51]: This guides what a venture fund like TLCom looks for, and the set of criteria they use to make investment decisions.

Ido [05:56]: Is this a big enough market, is this a good enough team, is this a good enough investment case. And, these are three different questions and that's the order in which we ask them.

Justin [06:05]: As we discussed two episodes ago, the market size conversation is a complex and nuanced conversation - and expanding across the continent to achieve the scale VCs are seeking is equally complex.

And as a result, to Ido's second consideration, it requires a certain set of entrepreneurs and teams that have the capability to pull it off.

Ido [06:22]: Of course, we're looking for strong technology but much more than that we're looking for people that have some very deep insight around the problem they are trying to solve. So, people usually have this insight either from experience in the industry or had spent a lot of time researching it and studying it. Strong majority of the cases we come across - the differentiation is not in and around the tech side. It's much more about the ability to execute and operate.

Justin [06:52]: Ultimately, that comes down to the team and the entrepreneurs.

Chidinma [06:55]: We're in the people business.

Dayo [06:56]: For us, most importantly is the people behind the product and solutions. We typically seek founders who have a clear understanding of the problem they're trying to solve, founders who have the expertise to actually solve these problems, have demonstrated a level of persistence, ambition, track record and the passion for changing the status quo.

Justin [07:22]: And for Microtraction, it means looking for a specific founding team.

Dayo [07:25]: We like to work with cross-functional teams, of say 2 to 3 founders, that have at least one technical co-founder.

Chidinma [07:35]: We invest in technology-enabled businesses. Nigeria's operating market is extremely difficult and one of the difficulties stems from actually finding talent. Because we invest in tech-enabled companies, technology is the cornerstone of the idea, right, on you executing. So if you don't have somebody with technical background that's actually going to help you build out the tech, it's very difficult to acquire that person.

Justin [08:14]: If we focus narrowly on these issues discussed - a clear picture starts to emerge. VCs are looking for a very specific type of entrepreneur or startup to invest in - one that has a team that can demonstrate the ability to solve a large scale problem in Africa, preferably across multiple markets. And understanding that, we can explore what seems to be a pervasive narrative around venture investing - that there is scarce deal flow. And when we talk about a lack of deal flow, we're not talking about lack of startups, but lack of investable startups.

Dayo [08:41]: Africa is not suffering from a dearth of startups. Talented entrepreneurs with great ideas abound, in different sectors on the continent. So the question is, are they speaking the investor language?

Justin [08:54]: And in understanding what VCs are looking for, it helps guide what founders ought to be thinking about when fundraising.

Dayo [08:59]: Founders have to think about having the right team, having the right story, knowing which problem is being solved, being aware of regulatory issues, developing points of differentiation, understanding where units of profitability would be rich. These are all obvious talking points for an investor, but not necessarily for founders, who are most times first time founders. That doesn't mean that they are investment-ready just because they have a business, right? But they have to be able to articulate the potential to the investors or the knowledge of how to advance this business to a point where an investor would actually commit.

Justin [09:41]: This is a sentiment echoed by Peter Kisadha, the co-founder and CEO of Digest Africa, whose platform and database services VCs investing around the continent.

Peter [09:49]: I focus on the quality of deal flow. There is lots of deal flow. The question is - do we have companies that are worthy of that? Do we have the type of entrepreneurs that you would want to place your money into?

Justin [10:03]: And if the issue isn't deal flow, but quality deal flow, it puts pressure on VCs to find companies worth investing in -

Peter [10:08]: A person who has raised a fund faces more pressure to deploy that capital. We should see money raised entering the ecosystem because people are raising funds. So many early-stage funds are being raised and all of this capital has to be deployed.

Justin [10:21]: A VC may have a $10 million fund, but the question really is - how much of that fund have they deployed? And if venture investors are raising money pitching a pan-African narrative and an African growth story, yet if the startups and entrepreneurs with the specific characteristics required to realize that growth and scale are scarce - what does that mean? How are venture investors reconciling? And what models are they using to overcome these impediments to scale?

Justin S [10:46]: We weren't looking for unicorns - that's just unrealistic.

Justin [10:50]: That's Justin again with 4Di Capital, who we heard from in the opening. One way that venture investors are reconciling the existential challenges in this environment is by adjusting their return expectations accordingly.

Justin S [10:59]: We couldn't quite do the fence swings and hope that 1 in 10 makes it. It needed to be slightly more balanced. We had to try and focus on businesses that we thought were slightly more sustainable or feasible - not a total moonshot, but still with serious scaling potential. But also that could survive in an environment where funding is hard to come by.

Justin [11:20]: Justin here is talking about an element of the ecosystem that seems to be a common theme in this environment - where there is funding scarcity, limited track record, and complex markets. That element is a balanced portfolio.

Ido [11:30]: I do believe that some will be double-digit returns and there won't be nine write-offs and one big success. We'll be a little bit more balanced than this.

Justin [11:40]: That's Ido with TLCom again.

Ido [11:42]: I don't think we will have any 30, 40, 50x - that's not the assumption.

Justin [11:47]: However, a balanced portfolio doesn't mean lesser return expectations.

Ido [11:51]: Real asset allocations would not really care that we're in Africa and we just ran out of electricity or it's been really rainy. When they take an allocation decision they choose between alternatives and they will always choose the best risk-return adjusted profile, and we need to be up there with the other alternatives.

Justin [12:07]: This is also seen with how the fund measures success.

Ido [12:10]: The only measure of success for this fund will be the ability to raise the next two funds. And the only way to be able to do that will be to return money both in cash-on-cash terms and in IRR terms that is market. And market being not Africa but market being the global market.

Justin [12:28]: After all, local investors and entrepreneurs alike are competing on a global scale.

Chidinma [12:32]: There's a finite pool of capital and everybody is competing for that capital.

Justin [12:36]: That's Chidinma again, with Microtraction.

Chidinma [12:39]: And we cannot rely on our local HNIs to actually fund all of the startups that could come from here, from pre-seed to Series C. So that means, you're raising funds on a global scale.

Justin [12:56]: And with any investment, capital allocators are always comparing their options.

Chidinma [12:59]: For an LP, they're looking at their opportunity cost. I have a finite pool of money, and you're telling me to put it in you but that you can only return me 2x. And then I have someone else pinging me and saying put it in me and you'll see 10+x return. The LP is going to want to - unfortunately, it's not charity, this is a business, you're in the business of making money.

Justin [13:37]: When looking at the challenges to this ecosystem, as discussed, the difficulty with achieving scale is enhanced by an entrepreneur's lack of experience working in businesses at scale, or being a part of other firms as they scale. This exacerbates the talent challenge and gap, and many venture investors recognize that there are much needed non-financial resources to help startups and entrepreneurs realize the scale investors are seeking.

Ido [13:59]: We of course first and foremost write checks - and this is what people are coming to see us for. But alongside providing money, I think what we have learned - is that there is a lot more to do than to invest. It's much more about business building than investing.

Justin [14:12]: And there are a category of venture investors whose business and investment model is to commit to business building. One such firm is the venture development company Founders Factory Africa.

Lwazi [14:20]: I'm Lwazi Wali, I'm head of venture sourcing at Founders Factory Africa, which is a venture development company. What we exist to do is we're here to build and scale 140 tech startups across the continent over five years.

Justin [14:34]: The reality is that building and scaling a startup is hard. Startups will fail, and as Dayo said, perhaps even more so on the continent. FFA believes that their co-building model is the remedy.

Lwazi [14:44]: We are actually hedging for a lot of that failure through the venture development structure. It's really that support structure that's the difference between $500 million raised in 2018 in VC deals in Africa versus $79 billion in the US in the same year. This gap in our opinion is not one of American founders are stronger or smarter than African. We have actually taken the opposite view and are very bullish on the continent in that if the difference is not background or opportunity, it's support structure behind them, What we exist to do is to solve for that gap in support, and not just generic advice based support, ours is very much about co-building.

Justin [15:27]: Founders Factory has built out a world-class team of developers, data scientists, designers, product managers to work as an extension of their portfolio's teams. And the goal is to pool resources and expertise to help early-stage startups achieve product-market fit and raise follow on funding to scale.

Lwazi [15:42]: In our opinion, the problem for Africa is not one of not enough capital - in fact, there's too much capital just chasing very few ideas - so irrigate the value chain or pipeline, I think you'll start to see capital move across both startup growth and all the way to exits.

Justin [15:57]: And back to the question of deal flow -

Lwazi [15:59]: The issue we have here is there are not enough investible products or businesses, and so the work becomes - how do you get that business to a place where it can absorb capital?

Justin [16:15]: Now, Founders Factory Africa applies a pretty similar funding model to global accelerators or incubators - a combination of cash and services for an equity stake in their portfolio companies. But that's not the only venture building model focused on the continent -

Maxime [16:27]: My name is Maxime Bayen. I'm currently working as senior company builder with GreenTec Capital.

Justin [16:34]: We heard from Maxime earlier this season, and the firm he currently works for - GreenTec Capital Partners - employs a unique model to venture building.

Maxime [16:41]: The way GreenTec works is that we have a model called results for equity, through which we're supporting very early-stage startups and with them we agree on a number of KPIs that we want to achieve and those are metrics in which we as GreenTec believe we can support them. When those KPIs are reached, GreenTec receives equity in return.

Justin [17:03]: GreenTec is providing resources in lieu of funding because it's these very resources that the early-stage businesses they are working with would use the money for if they chose to raise a traditional funding round.

Maxime [17:14]: But what we're telling them is - ok, what is your problem right now? What do you need funding for? You need funding because you cannot access, for instance, a decent financing solution to finance your working capital. Well, don't raise funding from investors to solve these problems, there's also other solutions that we can help you to identify. You need funding because you need to hire a CFO that will help you reaching out to investors, we can help you with that.

Justin [17:37]: GreenTec's value proposition and desired impact is clear -

Maxime [17:40]: It's basically trying to reduce the funding needs by providing them support on areas they thought initially they would need funding to fill those areas. Which also has the advantage to limit the amount of equity they give away and the dilution of their capital.

Justin [17:59]: The venture building model and GreenTec's results for equity model is all about incentive alignment. So too is corporate-backed venture. On one hand, you have corporate-funded venture investing.

Lwazi [18:08]: We took the POV of raising more strategic or smart capital

Justin [18:14]: That's Lwazi with Founders Factory Africa, again. In complex environments, it's all about smart capital and incentive alignment - and working with - not against - corporates who have long figured out how to win in these markets.

Lwazi [18:25]: And really the insight behind that - or the POV that we approach it with is because when you look at the fact that almost 80 or 90% of startups fail, a lot of them struggle between that death valley of growth to scale, which is where we sit, and when you need to scale what you typically need for a startup is access to distribution channels, access to expertise, regulatory issues. So we found that those are really the bottlenecks to scale, and when you think about who's actually solved scale - it's corporates.

Justin [18:57]: Much like entrepreneurs are raising strategically, so too are venture investors like Founders Factory.

Lwazi [19:02]: I would expect to see more corporates playing this role of venture capital or investors just because, again, in Africa corporates hold a lot of capital and power here. Which for me is actually exciting because it's more informed capital.

Justin [19:17]: And these kind of partnerships allow each party to do what they do best.

Lwazi [19:21]: Corporates are really good at doing what corporates do. Venture building at this level of rapid iteration and growth is a very unique skillset. If you looked at how this market worked before, you have corporates on one side and startups on the other, always at loggerheads because the one feels the other is threatening or the other feels the other is too slow. We took a position as Founders Factory to say: actually, why are these two fighting? If anything it's a very synergistic and symbiotic relationship.

Justin [19:50]: And apart from potential financial returns, these models have other tangible benefits for corporates too.

Lwazi [19:55]: It's a nice way for them to de-risk innovation. You, one, get access or insight into startups and people who are potentially disrupting you over the next 3 to 5 years. Two, you get to learn, as part of venture scaling and building, in finding 100 we'll probably have to go through thousands, so a big gap in the market here is due diligence here and data on startups and communities.

Justin [20:23]: Beyond this, traditional corporate VC models - in which corporates start venture capital funds within the business - have practical impact given where the money is coming from.

Zach [20:31]: Corporate venture capital funding comes out of corporate balance sheets.

Justin [20:35]: That's Zachariah George, the co-founder and Chief Investment Officer of Startupbootcamp Africa.

Zach [20:39]: Corporates are cash-rich, so the whole theory is instead of paying out dividends, if you look at the major corporates in Africa they're just flush with cash. If you look at someone like a Google or Amazon or Samsung, or a large corporate, they may not have the intellectual firepower of traditional VC that's done deals for decades, but they have the balance sheet and they have the strategic assets that can help portfolio companies.

Justin [21:08]: And funding out of corporate balance sheets lends itself to flexibility from a timing perspective - flexibility that a traditional closed-end fund may not if they're expected to return capital to their investors in 10 years.

Alex [21:18]: One of the beauties of Omidyar Network and models like it

Justin [21:22]: That's Alex Lazarow, currently a global venture capitalist and author of Out Innovate: How Global Entrepreneurs - From Delhi to Detroit - Are Rewriting the Rules of Silicon Valley, and who is also formerly of the impact investor Omidyar Network.

Alex [21:33]: is that structurally they have the ability to have a longer-term outlook. And that's because Omidyar didn't have a 10-year fund that had to return capital at the end of it - it was essentially an evergreen structure.

Justin [21:46]: The benefits of evergreen structures are the same benefits that corporates VCs experience when their funds are invested out of their balance sheet.

Alex [21:52]: There's a couple examples of businesses like that that are investing in emerging markets and are evergreens - I think Naspers is one, which is a publicly-traded company, but that isn't a fund. They invest out of the broader company.

Justin [22:04]: It's a model that reflects not only the fact that companies elsewhere in the world are staying private for longer than the 10 year fund window, but also to address some of the realities of the African ecosystem.

Alex [22:13]: I think that's one of the things that I'm pretty interested in is - how does the venture capital model get evolved or changed for the reality of building in emerging markets, where timelines might be longer, where there might be less capital, where the nature of the business model might be different - and I think evergreens are an interesting structure that solves for part of that, which is they give the opportunity to have a longer-term outlook.

Justin [22:44]: So to summarize - VCs are looking for scale, and their business model dictates that they invest in and support startups with the potential to grow to a certain scale, and ultimately, exit and create a return for their investors at a certain scale. But the business environment, scarcity of experienced talent, market size and expansion considerations make achieving that scale incredibly difficult on the continent. So how are venture investors reconciling?

By balancing their portfolio more than, say, a Silicon Valley VC may. Or by pursuing venture development initiatives, aligning themselves with their own strategic investors like corporates, or by leveraging evergreen structures to reduce time pressure put on startups to exit. These are but a few models employed on the continent today that are worth exploring further.

And as always, my b mic Sayo and I have some thoughts, as we sat down to discuss our view on the venture investing ecosystem today -

Sayo [23:35]: I'd be interested - and I guess a little bit of the fundraising lens from the institutional guys who you spoke to seems to be outward-looking. We didn't talk about the opportunity cost of the dollar of local investors, which is also an interesting point.

Justin [23:56]: Say more…

Sayo [23:57]: In Nigeria, for instance, the opportunity cost of putting your money in an oil and gas services company versus a tech investment, is quite vastly different and requires a pretty strong and long worldview to do that.

Justin [24:15]: Well I guess I suppose it's the same thing in South Africa where there's a very robust public market and also you can open a savings account and get 12% return. And so, it's certainly not guaranteed in this environment that you can invest in this asset class and get a comparable return, and it's a lot more difficult.

Sayo [24:38]: Yeah, and even beyond - beyond corporate VC, I think there's another kind, a similar kind of thing which is like HNI VC.

Justin [24:48]: They call it like super angels.

Sayo [24:49]: Yeah, which actually you can - so a corporates motivations behind doing venture is to increase its product set, get more customers, get more revenue, cut down costs. Some of it is also to cannibalize itself - paying attention to trends and things that are going to be threats to them in the future and essentially being part of those conversations. And, I think the same actually applies to big, private businesses and family offices, where you can essentially de-risk your businesses by investing into technology that will enable it and/or cannibalize it in the future.

Justin [25:37]: How much of it, with HNIs and family offices, is also just that people are interested in playing in this space, they're intrigued, they want diversification, they want to get involved in tech, they want to get involved in Africa, and they may just have a risk tolerance to do it and it's nothing more than that.

Sayo [25:56]: I guess I'm saying, why would they have that risk tolerance? Like, I think that's true everywhere.

Justin [26:04]: Amongst local or foreign family offices?

Sayo [26:07]: Some people just think it's cool, they read about it, they want to do it. I think that’s true everywhere. It's more like - Why do they think it's cool? Why do they still do it? How do they think about that risk-return?

I think a venture model does work, and maybe it's not clear enough that some people are taking a venture approach

Justin [26:26]: What do you mean?

Sayo [26:27]: So you can pick 10, 1 wins, and you're happy.

Justin [26:32]: And are people taking that approach?

Sayo [26:34]: I think so. I think some people, more depending on where the funds are coming from, where in this funnel or stage of companies they're investing in, some people take that view.

Justin [26:44]: I guess the question there is that a sustainable, scalable way based on the very nature of the fact that there aren't so-called unicorns or billion-dollar companies, so there's thus far a ceiling to the return expectation of the 1. And then are the fund sizes thus far big enough to allow people to make enough bets?

Sayo [27:08]: I think what you're trying to say is if I need 100x from 1 company out of 10 but the maximum X I can get is 50, then I need 2.

Justin [27:20]: That's what I'm saying.

Sayo [27:21]: Yeah, I'm not sure that you're wrong, but I guess what I'm saying is that you can still take an approach of I don't need the majority of my companies to be successful. Whatever that number is I don't think that it's so big that it stops being venture capital in that way. What I do think is that it's - and I think the point made through the episode which is good is just that in a global landscape where we are competing, there's an opportunity cost for every dollar raised essentially, it's more difficult to sell that story to an investor. But I think if you're looking at a family office, patient capital,

Justin [28:07]: DFIs…

Sayo [28:08]: DFIs, someone with a view. I don't think that necessarily it wouldn't work. I think it's ust a reality of - and I don't think that the episode is saying that venture is inappropriate for the region. I think what you're saying is that to be competitive on a global scale, there needs to be a more robust or different approach to how you invest.

And I think it'll be better for entrepreneurs, better for the ecosystem, better for everybody if everybody was clear on their worldview. If you really think that you need profitable businesses from day 1, say it upfront. Make that a criteria, work out how you're doing to find them. If scale is the most important, then don't be sitting looking at profitability for months and months and due diligence. I understand the importance of it, of getting a rounded view, but if that communication needs to be clearer, cause if you're patient capital - be patient. And I might have said this before but not enough VCs are entrepreneur-led on the continent. I hypothesize that venture capital lends itself much more to entrepreneurs than any other type of asset investing.

Justin [29:26]: Mhm, it's starting to happen but the problem is there's just a scarcity.

Sayo [29:29]: Yeah, I mean there's no exits - that's how entrepreneur-led VCs start. But I do think that that's really important in terms of being able to have a worldview, being able to operate with a sensitivity of the experience you're creating for people around you.

VO [29:48]: That's it for this episode of The Flip. Next episode, the final episode of our three-part series on venture investing in Africa, we take the conversation one step further and dive deeper into what other funding models may be best for the realities on the ground. Until then, as always, you can join the conversation on social media @theflipafrica, and sign up to our newsletter on our website theflip.africa. Thanks for listening and we'll see you next time.